Informed Trading and Required Returns : The Influence of Public Information

We separately investigate the pricing relevance of informed trading predictable from public information, and that of unpredictable idiosyncratic informed trading that potentially captures private information. We use a direct profitability-based and immediacy-driven measure of price-relevant informed trading, and not the problematic PIN measure used in extant studies. Our empirical analyses fully control for any liquidity-related effects. We find that risk-adjusted required returns are significantly higher for firms with higher expected levels of price-relevant informed trading based on public information. These findings hold in both the cross-section and the time series. For example, a long-short portfolio based on the expected level of informed trading attributable to skilled processing of public information has annualized abnormal returns of 9.45%. When limited to the smallest quintile of stocks, these annualized abnormal returns grow to 29.30%. Furthermore, we also find that the relation between required returns and public information based informed trading is weaker in firms with more analysts and better accrual quality, suggesting that the information risk arising from skilled public information processing depends on the competitiveness and transparency in the firms’ public information environments. Overall, our results are supportive (from different perspectives) of extant theoretical models – Grossman and Stiglitz (1980), Easley and O’Hara (2004), Hughes, Liu, and Liu (2007), and Lambert, Luiz, and Verrechia (2011)